The Treasury Auction Shell Game

Very few people have either the time or patience to sift through the data released by the Treasury Department in the wake of its bond auctions. But the numbers do provide direct evidence of the country’s current financial condition that in many ways mirror a financial shell game that typifies our entire economy.

Despite continued deterioration of America’s fiscal health, the Treasury is still attracting adequate numbers of buyers of its debt, even with the ultra low coupon rates. Market watchers take these successful auctions as proof that our current monetary and fiscal stimulus efforts are prudent. But who’s doing the buying, and what do they do with the bonds after they have been purchased?

Most people are aware that foreign central banks figure very prominently into the mix. They buy for political reasons and to suppress the value of their currencies relative to the dollar. And while we think their rationale is silly, we do not dispute that they will continue to buy as long as they believe the policy serves their own national interests. When that will change is harder to determine. But another very large chunk of Treasuries go to “primary dealers,” the very large financial institutions that are designated middle men for Treasury bonds. In a late February auction, these dealers took down 46% of the entire $29 billion issue of seven year bonds. While this is hardly remarkable, it is shocking what happened next.

According to analysis that appeared in Zero Hedge, nearly 53% of those bonds were then sold to the Federal Reserve on March 8, under the rubric of the Fed’s quantitative easing plan. While it’s certainly hard to determine the profits that were made on this two week trade, it’s virtually impossible to imagine that the private banks lost money. What’s more, knowing that the Fed was sure to make a bid, the profits were made essentially risk free. It’s good to be on the government’s short list.  

Given that the Treasury is essentially selling its debt to the Fed, in a process that we would call debt monetization, some may wonder why it doesn’t just cut out the middle man and sell directly. But the Treasury is prevented by law from doing this, so the private banks provide a vital fig leaf that disguises the underlying activity and makes it appear as if there is legitimate private demand for Treasury debt. But this is just an illusion, and a clumsy one to boot.

One wonders how the market could be soothed by these results when they are so clearly manipulated. But the more important question is when the foreign governments reverse their currency policies, and when the investment banks are no longer guaranteed a quick short term profit, will there be anyone left willing to show up at Treasury auctions? 

According to the Office of Management and Budget, the U.S. government is expected to run a $1.6 trillion deficit in fiscal year 2011 (which expires in September). The Federal Reserve’s current quantitative easing program is taking down a large share of that red ink. But “QE2” expires in July, and in fiscal year 2012, the Federal government is projected to run a $1.1 trillion deficit (that of course could grow if the economy weakens). An additional $1.1 trillion in Treasury notes and bonds will mature over that 12 month period. So in total, the Treasury will need to issue a total of at least $2.2 trillion in notes and bonds in FY 2012. This translates into quarterly borrowing needs of approximately $550 billion, more than double the average of the last two quarters. To put this into perspective, the entire U.S. personal savings rate is about $650 billion annually. Even if every dime of this amount were ploughed into Treasuries, we would still need to borrow or print another $1.6 trillion.

At the height of the financial crisis in Q4 2008, the Treasury issued a record $560 billion of notes and bonds. Fortunately for them, that spike corresponded neatly with huge inflows of funds into Treasuries as investors sought safety from collapsing equity and corporate debt markets. Will the Treasury catch that break once again? There may be another financial panic, but will investor reaction be the same this time around? Bill Gross, the founder and chief investment officer of PIMCO, the world’s largest private purchaser of bonds, recently announced that he is reducing his Treasury holdings to zero. It is not clear what would convince Gross to get back into the market with both feet, but one might expect at minimum it would take much higher interest rates.

If private investors stay on the sideline, how does anyone expect the Treasury to sell its inventory without the support of a quantitative easing program from the Fed? Do they expect the Chinese to reverse course on their current policy and start heavily buying U.S. debt once again, irrespective of the damage to their own economy? That seems extremely unlikely given the drift in Chinese currency policy. More likely the Fed will remain the only buyer, meaning QE3, 4, and 5, are all but certainties. There should be no remaining doubts…the U.S. Government intends to monetize its own debt. Of course, as bad as things will be if QE  ends, it will be that much worse the longer it continues.

Despite recent volatility, the market has held up pretty well this month and appears to have found its footing in the past three days. Clearly, the downturn could’ve been worse given the headlines coming from Japan, Libya and the Mid-East generally — not to mention America’s ongoing struggles with high unemployment and the bursting of the housing bubble.

Lest you lapse into a false sense of complacency, we bring you Gary Shilling’s 5 Things to Worry About:

Japan: Looking beyond its horrific humanitarian and environmental disaster, Shilling sees Japan facing a problem financing its rebuilding effort. Currently, only about 6% of Japanese government bonds (JGBs) are owned by foreigners (vs. over 50% of U.S. Treasuries), which has enabled Japan to fund its deficit spending at extremely low rates: 10-year JGBs yield 200 basis points less than comparable Treasuries.

But Shilling expects Japan’s trade credit account surpluses to dwindle in the coming months and years. In the short term, Japan will need to import more materials and energy to powers its rebuilding efforts and will have its exports cut by the shuttering of much of its manufacturing capacity. In the long term, he sees Japanese exports falling as U.S. consumers continue to retrench and their surpluses eventually turning negative.

“They could very well have trade and current account deficits in next couple of years and that means they’ll have to import capital…and they’ll have to pay up for it,” Shilling says. “Then that debt, [already] over 100% of GDP, really starts to get expensive. It could be a very tough situation.”

Housing: Following a 9.6% drop in February existing home sales, median home prices are now at the lowest level since 2002. Citing the “huge overhang” of inventory of homes for sale – both listed and in the “shadows” – he predicts another 20% decline in national home prices over the next few years. That, in turn, will put more stress on consumer spending and push more mortgage holders under water, prompting another round of “strategic defaults”, a.k.a. jingle mail.

China: As detailed here, Shilling expects a “hard-landing” for China, where authorities are trying to mop up excesses created by their massive 2008 stimulus (12% of GDP vs. 6% for America’s). “They got inflation and a property bubble and they’re trying to tighten up,” he says. “I don’t think most people expect a hard-landing, which would be dropping back to 5-6% real GDP growth from double-digits now.”

Energy Prices: “A Middle East oil crisis is suggested by the riots and/or government overthrows in Tunisia, Libya, Egypt, Algeria, Yemen and Bahrain as well as rumblings in Saudi Arabia,” Shilling writes in the most recent edition of Insights. “Remember that the first oil crisis in 1973 when the Saudis suspended oil exports and the second in 1979 in the aftermath of the Iranian revolution were both associated with major recessions.”

Europe’s Debt Crisis: Time prohibited us from exploring it in the accompanying video, but Shilling – like many others – is concerned that Europe’s sovereign debt crisis could lead to a banking crisis and potentially the dissolution of the euro.

Of course, the optimistic spin on this is that one, these issues are “known knowns” and arguably priced in at current levels. Two, if the market climbs a wall of worry, there’s plenty of fuel for additional upside after the recent hiccups.

The United States is on a fiscal path towards insolvency and policymakers are at a “tipping point,” a Federal Reserve official said on Tuesday.

“If we continue down on the path on which the fiscal authorities put us, we will become insolvent, the question is when,” Dallas Federal Reserve Bank President Richard Fisher said in a question and answer session after delivering a speech at the University of Frankfurt. “The short-term negotiations are very important, I look at this as a tipping point.”

….read more HERE

Black swans…white swans…and big, nasty birds…

The weather is beautiful here in Paris. The sun is shining. People are returning to sidewalk cafes. Trees and flowers are beginning to bud out and bloom. Early spring in Paris can be delightful…or horrible. Be sure to pack a warm sweater and a coat…and hope you don’t need them.

Prepare for the worst; hope for the best. That is our unofficial motto, here at The Daily Reckoning.

Dow plus 178 points yesterday. Oil over $100. The euro is rising (dollar falling). Gold is back at $1,426.

And Warren Buffett is the latest to get on board with our Trade of the Decade – or at least, half of it.

Warren likes the buy side. Buy Japan, he says. It’s cheap.

But watch out, Warren; the yen is not cheap. You could win on the stocks…and lose on the currency.

That’s why we covered both sides in our Trade. Buy Japanese stocks. Sell Japanese bonds. And be prepared to wait.

Warren’s recommendation is typically positive and upbeat. He thinks the worst is passed in Japan. He’s now hoping…and expecting…better times. Japan’s stocks are a good deal, he says. You get a lot for your money. Things will improve.

Our view is not exactly cynical, but we don’t think the disasters are finished in Japan. We prepare for the next one.

“What,” asked an astonished French colleague. “They’ve had the biggest earthquake ever…the biggest tsunami ever…and a nuclear disaster too? What else could happen…a giant meteor?”

Our friend Nicholas Taleb has added “black swan” to the vernacular. Lately, there are so many of them, we barely have time to recover from the excitement of one black swam before another one bites us on the derriere. There seems to be a whole flock of them.

A reporter recently asked a popular analyst “what black swans do you see on the horizon?” Daily Reckoning readers will recognize the absurdity right away. A black swan is something you can’t anticipate. It doesn’t present itself as a possible problem, on the horizon. You can’t see it. Instead, it comes out of the blue, a problem you didn’t imagine at all.

But now, the whole world is wasting its time looking in the bulrushes for more black swans.

They would do better to examine the feathers of those snow-white birds in front of us. They’re imposters. They’re frauds. They’re white swan impersonators. They’re really gray, nasty swans…with mean tempers and prone to sudden acts of violence…

What do we mean?

Well…glad you asked.

For one thing, there is QE2…swimming around…with a bright, new coat of white paint. Here’s the latest from Bloomberg:

Maybe Bloomberg has its tongue in its cheek. Or maybe it really thinks QE2 is a great success. But the jump in inflation expectations is not necessarily a good thing.

Yes, stocks are up. And yes, so are junk bonds. You put in $100 billion per month; you have to expect something to happen. But what we see is an increase in speculation – and some bouncing around on the hard pan of a Great Correction. And yes, unemployment – as measured by the Labor Department – is down to its lowest level “in almost two years.” But 2009 was hardly a good year for jobs. And there are still 7 million fewer jobs today than there were before the Great Correction began in ’07.

No jobs; no income. No income; no shopping. No shopping; no real growth in the consumer economy.

The swan painters say Bernanke’s QE2 has boosted stock prices (right!)…and that higher stock prices increase Americans’ wealth (right again)…and that wealthier people will buy more, leading to real GDP growth (uh…not quite).

Relatively few people own stock portfolios. Those who do are aware that stocks go up and down. They’re buying stocks, but they aren’t necessarily convinced that this wealth is spendable; it hasn’t been around that long.

Meanwhile, far more people own houses than stocks. And houses are going down. Here’s the news from Reuters:

Sales of previously owned US homes fell unexpectedly sharply in February and prices touched their lowest level in nearly nine years, implying a housing market recovery was still a long off.

“If the price declines persist, even with the job market recovery, that could hamper recovery in the housing market,” said NAR chief economist Lawrence Yun.

Let’s see, nearly an entire decade of house price gains have been wiped out. Now one out of 7 houses in Nevada is empty! And next month begins the next big wave of resets, recasts, and foreclosures.

Is QE2 a happy, nice, white swan? Could it have a black heart? Maybe this swan is harmless, but we wouldn’t get too close.

We’ll return to this tomorrow…and to Japan, which faces a Godzilla bird of its own…

Bill Bonner
for The Daily Reckoning

Since founding Agora Inc. in 1979, Bill Bonner has found success and garnered camaraderie in numerous communities and industries. A man of many talents, his entrepreneurial savvy, unique writings, philanthropic undertakings, and preservationist activities have all been recognized and awarded by some of America’s most respected authorities. Along with Addison Wiggin, his friend and colleague, Bill has written two New York Times best-selling books, Financial Reckoning Day and Empire of Debt. Both works have been critically acclaimed internationally. With political journalist Lila Rajiva, he wrote his third New York Times best-selling book, Mobs, Messiahs and Markets, which offers concrete advice on how to avoid the public spectacle of modern finance. Since 1999, Bill has been a daily contributor and the driving force behind The Daily Reckoning .